3.3.2.1 Types of derivatives
A derivative is a “financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables” (Hull, 2006). Japanese yen forwards, futures, and call and put options, for example, are derivatives whose underlying asset is the Japanese yen. The buyer (seller) of a Japanese yen forward contract has the obligation to buy (sell) a fixed number of Japanese yen at a particular date at a fixed exchange rate. Futures contracts are similar to forwards contracts with regards to the obligations of the buyer and the seller. While forward contracts are customized contracts whose terms are
fixed by agreement between the buyer and the seller, and are said to trade over-the- counter (OTC), futures contracts are standardized contracts which are traded on futures exchanges. The buyer of a Japanese yen call (put) option has the right to buy (sell) a specified number of Japanese yen sometime in the future at a fixed exchange rate. A swap is an agreement between two parties to exchange a series of cash flows over the term of the swap. One series of cash flows could be fixed, and the other series could be floating, or both series could be floating. The floating cash flow is tied to an index such as an interest rate, currency exchange rate or the price of a particular commodity. Accordingly, swaps may be classified into interest rate swaps, currency swaps and commodity swaps.
A key feature distinguishing the derivative is the ‘linearity’ of the instrument (Froot et al, 1994; Tufano, 1996; Servaes et al, 2009). For example, the buyer (seller) of a forward contract is obliged to take (make) delivery of the underlying asset in exchange for a fixed delivery price. If the asset price rises (falls), the buyer (seller) makes a profit and vice versa. Hence, the payoff to the buyer (seller) is linearly dependent on the price of the underlying asset. This is also true in the case of a futures contract and a swap contract, under both of which the participants have certain obligations. This is not true in the case of options, however. A buyer of a call (put) option has the right to exercise the option on or before the expiration date and will do so only if the underlying asset price is higher (lower) than the option’s exercise price. When the option is not exercised, the buyer loses only the premium price initially paid to purchase the option. When the option is exercised, the buyer makes gain. Hence, the payoff to the option buyer is non-linear. When the quantity to be hedged is unknown it is argued that a non-linear financial
instrument provides better protection (Brown and Toft, 2002; Servaes et al, 2009). Another feature that distinguishes different derivatives is the characteristic of the market. While futures contracts are exchange-traded, forward contracts and swaps are OTC products, while options are traded both on exchanges as well as OTC (Bodnar et al, 1995). This feature shapes the cost structure of the instrument and hence influences the selection decision (Smith and Stulz, 1985; Froot et al, 1994; Servaes et al, 2009).
3.3.2.2 Use of derivatives in risk management
Financial derivatives are used by firms to manage exchange rate risk, interest rate risk and commodity price risk.
Exchange rate risk may be classified into transaction exposure, translation exposure and economic exposure. An example of transaction exposure is that of a Canadian manufacturer which procures some of its input components from Japan and is invoiced in Japanese yen. The manufacturer could hedge the risk of a rise in its input costs due to a rise in the value of the Japanese yen by buying a forward or futures contract on Japanese yen or buying a call option on Japanese yen. These derivative contracts would rise in value with the increase in value of the Japanese yen, allowing the manufacturer to offset the increased cost of the input components. An example of translation exposure is that faced by a firm which has a foreign subsidiary whose assets and liabilities are denominated in a foreign currency. As the foreign currency exchange rate changes, the consolidated financial statements of the parent firm, which are denominated in the parent’s home currency, could record changes in the value of the assets and liabilities of the foreign subsidiary, even if these have not changed when denominated in the foreign currency. Finally, economic exposure to exchange rate changes arises if the sales of a
company are threatened by changes in exchange rates. For example, a Canadian company with a Japan-based competitor could see its global sales decline if the Japanese yen declined in value relative to the Canadian dollar. Froot et al (1994) cite the case of Caterpillar, which saw its “real-dollar sales decline by 45% between 1981 and 1985” when the U. S. dollar increased in value, as an example of a U. S. exporter which could have benefited by using derivatives to hedge its exchange rate risk. It is generally agreed that transaction and economic exposure should be hedged, while translation exposure should be hedged only if the parent company intends to liquidate its foreign subsidiary. Servaes et al (2009) reported that 93% of the participating firms reported an exposure to exchange rate risk, while 82% of the firms use foreign exchange derivatives. Geczy et al (1997) find that the source of foreign exchange risk influences the type of instrument used. Firms with foreign operations tend to use forwards or a combination of forwards with either futures or options. The surveys by Servaes et al (2009) and Bodnar et al (1995) both reveal that forward contracts are the instrument of choice of responding firms, followed by swaps and then OTC options.
Interest rate risk arises from a mismatch between the maturity of a firm’s interest rate investments and debt. For example, a firm’s debt may have three months to maturity, while its investments may have five years to maturity. If the short term interest rate increases, the firm will suffer a loss (Triantis, 2000). This is an example of interest rate risk exposure. The company could hedge its interest rate risk by entering into an interest rate swap with a swap dealer, under which it receives interest payments based on the three month interest rate (floating rate) and makes interest payments at a fixed interest rate. A company’s current and planned future positions in both borrowings and
investments determine its vulnerability to the future change in interest rates (Bacon and Williams, 1976). 73% of the firms surveyed by Servaes et al (2009) reported having at least 10% of debt with floating interest rates, and 79% of the responding firms use interest rate derivatives. The most used derivative is the interest rate swap (Bodnar et al, 1995; Servaes et al, 2009).
Exposure to commodity price risk is not as common as the exposure to exchange rate risk and interest rate risk, but is still a key risk (Froot et al, 1994) and stems from possible changes in the price of input and/or output commodities (Unterschultz, 2000). For example, in January, a chocolate factory could take a long position in sugar futures contracts to hedge the price of sugar required for its November production. If the spot price of sugar increases in November, the factory could close out its futures position at a profit, which would offset the higher price that it would pay to buy sugar in the spot market. While 49% of the firms surveyed by Servaes et al (2009) reported exposure to commodity price fluctuations, and 32% of the firms use commodity derivatives, most of the firms tend to manage commodity price risk with non-financial approaches like contractual arrangements, pricing plans and natural hedges in addition to the standard OTC financial derivative contracts. Bodnar et al (1995) concluded that there is no financial derivative that dominates commodity price risk management. Instead, commodity price risk is hedged through a variety of financial contracts including swaps, options, futures and forward contracts (Bodnar et al, 1995; Carter et al, 2004). In their case study on fuel hedging Essaddam and Miller (2008) find that both futures contracts and futures options are effective in managing price risk.
3.3.2.3 Limitations in using derivatives
There are several limitations in using derivatives to manage risk. Firstly, not all assets have corresponding derivatives. For example, there are no futures contracts on jet fuel, which has led airlines to use heating oil futures to manage the price risk of jet fuel. Secondly, the effectiveness of the instrument in hedging risk depends on the correlation between the movements in the price of the asset which is being hedged and the asset underlying the futures. In the case of airline jet fuel hedging, this is the correlation between changes in the price of jet fuel and the price of heating oil. Such a correlation may not always be high enough to make the derivative as effective as desired. Thirdly, the fixed size of the derivative contract may create difficulties in formulating the perfect hedge. For example, the Japanese yen futures contract traded on the Chicago Mercantile Exchange Group has a size of 12.5 million yen, making it difficult to hedge an exposure of 15 million yen. Fourthly, it is possible that a multinational company anticipates that it will have foreign sales denominated in foreign currency, but has no idea of the magnitude of these sales. Finally, exchange-traded derivatives have specific delivery/expiration dates that may not coincide with the date of the anticipated transaction that a firm wishes to hedge. Furthermore, the price of the hedge can be a severe impediment and as such may discourage hedging in certain cases.